China’s pre-emptive strike on OECD profit-shifting initiative

China has introduced measures to deny income tax deductions for certain service fees and royalties paid by Chinese companies to their overseas affiliates. They appear to stem from China’s initiatives to implement rules it sees as related to the OECD’s Base Erosion and Profit Shifting project (BEPS)

They will likely have a significant impact on holding structures, supply chain planning and cash repatriation strategies of multinationals…

Bulletin 16: China Makes a Pre-Emptive Strike on BEPS!

On 18 March 2015, the State Administration of Taxation of China (“SAT”)
introduced measures to deny income tax deductions for certain service fees and royalties paid by Chinese companies to their overseas affiliates. These highly controversial measures were published in Bulletin 161 and appear to stem from China’s initiatives2 to implement rules that it views as related to the OECD Base Erosion and Profit Shifting (“BEPS”) Project.

Bulletin 16 targets service fee and royalty payments made to affiliated companies outside China that do not undertake functions and risks and/ or lack economic substance. In the case of royalties, the focus is also on payments to companies that have legal ownership of the underlying intangible assets, such as intellectual property, but have not contributed sufficiently to the creation of value in the intangibles.

Bulletin 16 appears to be retroactive at least to 1 January 2008 and possibly as far back as 10 years, which is the statute of limitations for special tax adjustment cases.

The new measures in Bulletin 16 will likely have a significant impact on holding structures, supply chain planning and cash repatriation strategies of multinational companies (“MNCs”). At the same time, certain aspects of Bulletin 16 may be open to principled legal challenge depending on how the SAT and local tax bureaus interpret and implement the new measures.

What payments are not deductible under Bulletin 16?

Bulletin 16 introduces four categories of payments by Chinese companies to their overseas affiliates that are non-deductible from the taxable income of the Chinese company. These categories of payment are as follows:

• Outbound payments to overseas affiliates that do not perform functions, assume risks, and/or do not engage in substantive operational activities;
• Outbound payments to overseas affiliates for services that do not directly or indirectly give an economic benefit to the Chinese company;
• Outbound royalty payments to overseas affiliates that have legal ownership of the intangible property but have not made contributions to the creation of value in such intangible property, where the payments do not conform to the arm’s length principle; and
• Outbound royalty payments to overseas listed vehicles in exchange for incidental benefits arising from the listing activities.

These categories are broadly drafted and give a great deal of discretionary authority to tax officials about how to interpret and apply them. For example, it is not clear with respect to the legal owner of intangible property whether the funding of R&D activities or brand development, as opposed to the actual conduct of such activities, will be treated as a sufficient contribution to value creation to justify deduction of the royalty payment by the affiliated licensee in China. At the same time, however, the vagueness of these categories creates room for taxpayers to make legal arguments in favor of deductibility.

The new rules also highlight the importance of strong transfer pricing analysis to support that service fee and royalty payments meet the arm’s length standard even where such payments are not deemed to be nondeductible under Bulletin 16.

Transfer pricing rule or deductibility rule?

Although Bulletin 16 states in its introductory paragraph that it is a transfer pricing regulation, three of the four categories of non-deductible outbound payments do not refer to the arm’s length standard and therefore could be interpreted as deductibility rules. If the tax authorities apply these as transfer pricing rules, they must conduct a transfer pricing investigation and determine that the payments in question fail to meet the arm’s length principle before they can make a transfer pricing adjustment by denying the tax deductions. Furthermore, such a transfer pricing adjustment would result in the Chinese company that made the payment having to pay the additional income tax plus interest at prevailing rates, but would not subject the company to late payment surcharges or penalties. If, however, the tax authorities apply the Bulletin 16 categories as deductibility rules, the outbound payments in question may automatically become non-deductible without any transfer pricing analysis by the tax authorities. In this case, a tax authority might also make the Chinese company liable for late payment surcharges (at an annual rate of about 18.25%) and penalties (ranging from 50% to 500% of the tax).

We believe that Bulletin 16 should be interpreted and applied as a transfer pricing regulation and therefore that the tax authorities must conduct a transfer pricing investigation and conclude that payments do not meet the arm’s length principle before they can deny the tax deductions. The concern, however, is that local tax authorities may apply the vague wording of Bulletin 16 to simply deny deduction of outbound payments without conducting transfer pricing analysis. In a worst case scenario, the tax authorities may seek to impose late payment surcharges and penalties.

If a tax authority treats Bulletin 16 as providing deductibility rules and denies deduction of outbound payments without first determining that payments fail to satisfy the arm’s length principle, the decision may be subject to legal challenge based on the Enterprise Income Tax Law3 and its implementing regulations. For example, the decision may violate Article 8 of the law, which provides that “reasonable expenditures incurred by an enterprise in connection with the deriving of revenue” are deductible. The decision may also fail to meet the standard in Article 41 of the law and Article 111 of the implementing regulations that a transfer pricing
adjustment must be based on “reasonable methods” that are “consistent with the arm’s length principle”.

Value creation requirement for intangible assets under Article 5

Article 5 of Bulletin 16 introduces the concept of “value creation” for
intangible assets. The Official Explanatory Note to Bulletin 164 provides guidance regarding the definition of “value creation”. Specifically, it provides that the analysis of contributions to “value creation” should take into account the functions performed, assets used and risks assumed by relevant parties in the development, enhancement, maintenance, protection, application and promotion of the intangible assets, such as technology or brands. The explanatory note also states that royalties
should be proportional to the “value created” by the recipient of the royalties.

To some extent, Article 5 of Bulletin 16 seems to be in line with proposals under the OECD BEPS Project. The OECD BEPS Action Plan 8, “Guidance on Transfer Pricing Aspects of Intangibles” issued on 16 September 2014, states that the legal owner of intangibles is not automatically entitled to residual profit even though such profit may initially accrue to the legal owner.

However, the value creation requirements in Article 5 of Bulletin 16 may pose problems for IP holding companies that only fund and assume all of the risks associated with the development of IP but outsource all of the other functions, such as R&D work or brand building, to other entities. Bulletin 16 is unclear as to whether the legal owner has to physically perform these functions to be treated as contributing to “value creation” in the intangible asset. The OECD position is that “it is not essential that the legal owner physically perform all of the functions, but control is
a minimum”. Based on the OECD position, only where the legal owner neither controls nor performs the functions related to the development, enhancement, maintenance, protection or exploitation of the intangible, is the legal owner not entitled to any ongoing benefit attributable to the outsourced functions.

It remains to be seen whether the above OECD position will be accepted by the tax authorities in China as they implement Bulletin 16.

Tax consequences of non-deductible outbound payments

Where a Chinese company is denied a deduction for an outbound payment, the direct impact on the Chinese company is the payment of additional income tax plus interest. However, the possible further tax consequences for the Chinese company and for the overseas related party that received the payment are uncertain. Since Chinese tax law currently does not provide a basis for secondary adjustments, we believe that the nondeductible outbound payment should not be deemed as a dividend, loan or gift to the overseas recipient and no further tax impact should arise in this regard. However, it is not certain how the Chinese tax authorities will view this question.

Bulletin 16 does not provide for the refund or adjustment of withholding tax previously imposed on non-deductible outbound payments (e.g., royalties). Therefore, the MNC group may potentially be subject to double taxation in China where the outbound payment is non-deductible for the Chinese affiliate and withholding tax is imposed on the overseas affiliate.

What actions should MNCs consider?

Bulletin 16 is the latest in a series of steps the SAT has taken to aggressively scrutinize payments to overseas related parties. On 29 July 2014, the SAT issued Notice 146 requiring tax authorities at all levels to participate in a nationwide search for and investigation of all large payments of service fees or royalties from Chinese resident enterprises to overseas related parties. For a detailed discussion of Notice 146, please refer to our client alert in August 2014. In its April 2014 letter5 to the United Nations working group on transfer pricing issues, the SAT also took
a firm stance on intragroup service payments, calling for scrutiny of the benefits to the Chinese service recipients. For further discussion of recent cases involving transfer pricing adjustments for service fees and royalties, please refer to the January & February 2014 issue and the May & June 2014 issue of our China Tax Monthly.

In response to Bulletin 16, an MNC group that is charging service fees or royalties to Chinese affiliates should consider taking the following actions to safeguard its tax interests in China:
• Prepare or review cross-border service or license agreements to ensure that the service fees or royalties are charged at arm’s length in accordance with Chinese transfer pricing rules;
• Prepare detailed documentation to defend the reasonableness of service fee or royalty payments;
• Ensure that the overseas affiliate receiving service fee or royalty payments from China has sufficient substance;
• Review the contributions to “value creation” by the legal owners of intangible assets for which royalties are charged to affiliates in China;
• Avoid paying service fees or royalties to overseas affiliates in traditional tax havens; and
• Be well-prepared to challenge tax authority decisions on a principled legal basis, including the possibility of administrative review and litigation or competent authority procedures when necessary and commercially feasible.

Appendix I

Unofficial Translation Prepared by Baker & McKenzie

State Administration of Taxation’s Bulletin on Enterprise Income Tax Issues Related to Outbound Payments by Enterprises to Overseas Related Parties
(Document Ref. SAT Bulletin [2015] No. 16 Dated March 18, 2015. Effective from March 18, 2015)

In accordance with the Enterprise Income Tax Law of the People’s Republic of China (hereinafter referred to as “Enterprise Income Tax Law”) and the relevant rules of the Implementing Regulations thereof, in order to further regulate and strengthen the transfer pricing management of outbound payments paid by an enterprise to an overseas related party, the relevant transfer pricing issues in relation to outbound payments by an enterprise to an overseas related party are hereby announced as follows:

1. According to Article 41 of the Enterprise Income Tax Law, when an enterprise makes outbound payments to overseas related parties, it should follow the arm’s length principle. If the outbound payments to overseas related parties do not follow the arm’s length principle, the tax authority may make an adjustment accordingly.

2. According to Article 43 of the Enterprise Income Tax Law, when an enterprise makes outbound payments to overseas related parties, the in-charge tax authority may request that the enterprise provide the contract or agreement between the enterprise and the
aforementioned related party, and recordal documents proving that the transaction truly occurred and followed the arm’s length principle.

3. Outbound payments made by enterprises to overseas related parties that do not perform functions, assume risks, and/or do not engage in substantive operational activities should not be deductible when calculating the amount of taxable income of the enterprise.

4. When an enterprise makes an outbound payment for services provided by an overseas related party, such services should result in the enterprise directly or indirectly receiving an economic benefit. When an enterprise makes an outbound payment to an overseas related party for the following services, the payment should not be
deductible when calculating the amount of taxable income by an enterprise:

(a) Services that are unrelated to the functions performed and risks assumed by the enterprise or services that are unrelated to the operations of the enterprise;

(b) Services provided by a related party that exercises control, management and supervision over the enterprise in order to safeguard the investment interests of the investors that have directly or indirectly invested in the enterprise;

(c) Services provided by a related party to an enterprise that has already purchased the services from a third party or has already performed the services by itself;

(d) Services where the enterprise receives additional benefits solely for being part of a corporate group, and the enterprise has not received any specific services from related parties within the group;

(e) Services that have already been compensated as part of other related transactions; and

(f) Any other service that is unable to directly or indirectly bring economic benefit to the enterprise.

5. When an enterprise needs to pay royalties for the use of intangible property provided by an overseas related party, the degree of contribution to value creation in the intangible property by all related parties should be considered and economic benefit to be enjoyed by all parties should be determined. When an enterprise makes royalty payments to related parties that only enjoy legal ownership of the intangible property but have not made contributions to value creation in such intangible property, if such payments do not conform to the arm’s length principle, such payments should not be deductible when calculating the amount of taxable income of the enterprise.

6. Where a holding company or a financing company is established overseas for the main purpose of financing or listing, royalties paid to the overseas related party in exchange for incidental benefits arising from such financing or listing activities should not be deductible when calculating the amount of taxable income of the
enterprise.

7. Under Article 123 of the Implementing Regulations of the Enterprise Income Tax Law, when enterprises make payments to overseas related parties that do not follow the arm’s length principle, the tax authority may make special tax adjustments within 10 years from the assessable year in which the transaction took place.

8. The Bulletin shall take effect upon its issuance.

It is hereby announced.